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Benchmarking of CEO Pay Questioned

Using peer groups to determine executive compensation leads to inflation, a study charges.

Executive compensation and how to determine it remains a hot issue. A recent survey by Institutional Shareholder Services (ISS) finds executive pay is the top governance issue cited by institutional investors in both North America and Europe. The issue ranks second after board independence in the Asia-Pacific region and developing markets. Meanwhile, a controversial research paper by the University of Delaware’s John L. Weinberg Center for Corporate Governance claims the standard board practice of using groups of similar companies as a benchmark to determine CEO compensation is unjustified and leads to escalating compensation levels.

Charles Elson, chair of the Weinberg Center and co-author of the study published in August, says the basic premise of using peer-group benchmarking is flawed. It’s not just that selecting the companies to include in a peer group invites manipulation of the results, Elson says. Nor is it that compensation is typically set at the 50th, 70th or 90th percentile found in the peer group, he says, though “that is like Prairie Home Companion saying, ‘All the children are above average.’ It leads to a ratcheting up of all CEO salaries.”

Rather, Elson argues, the notion that CEOs can easily move to the top position at another company is not accurate. “There is really no external market for CEOs,” he says. “The skills of a chief executive are company-specific, involving experience, the relationships with other managers and executives and the culture of the company, and the odds of a CEO leaving a company over compensation are slim to none.”

Elson and co-author Craig Ferrere, a fellow at the center, argue that boards should look at internal factors, not peer-group benchmarks, to set top executive salaries.

Todd Lippincott, managing director for executive compensation in the Americas for consultancy Towers Watson, agrees that CEO skills are not readily transferrable, adding that this weakens the case for peer-group benchmarking. But he also argues that Elson and Ferrere overstate the extent to which corporate boards rely on this method.

“We find that companies use peer groups as one data point—an important data point for sure, but not the only one,” Lippincott says. “In many cases, they’ll use multiple peer groups—a narrow one of like-sized competitors, and a broader one. They also consider the state of the economy, overall employee compensation in the company and finally, performance. It’s not a knee-jerk, mechanistic approach.”

He says that while many companies and their boards are increasingly “diligent and thoughtful” about setting executive salaries in the wake of say-on-pay, they are doing an inadequate job on transparency and disclosure.

Shareholder concerns about the level of U.S. executive pay also have had an impact, Lippincott says. “In the last year, executive compensation has been essentially flat, and long-term incentive bonuses are flat to down.” He says that going forward, this could mean benchmarking leads to lower compensation levels.

Robin Ferracone, CEO of Farient Advisors, a New York and Los Angeles-based compensation consultancy, agrees that peer-group benchmarking has inflated top executive pay in the U.S., but says the challenge is to come up with an alternative.

“One way would be to use sharing ratios,” Ferracone says, citing the example of RLI Corp., an insurer in Peoria, Ill. “They share profits with their top executives” according to a formula for each position, she says, “so if the company does well, the executives do well.”

Since CEOs are not fungible, another idea is to establish a benchmark peer-group composed of four lower-ranked executives at the company, say CFO, COO, treasurer and controller, Ferracone says. Their skills tend to be less company-specific and more transferrable from company to company. “I’m thinking of trying this idea on some of the boards I work with,” she says.

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